Pre­par­ing for Europe’s next re­ces­sion

If you do not un­der­stand what is hap­pen­ing to the eu­ro­zone econ­omy, you are not alone. One day we are told that growth is def­i­nitely passé; the next that re­cov­ery is on track; and the third that the Euro­pean Cen­tral Bank is con­sid­er­ing send­ing checks to all cit­i­zens to boost out­put and re­vive in­fla­tion. Rarely has the eco­nomic pic­ture been so con­fus­ing.

Start with medium-term growth. Since the global fi­nan­cial cri­sis erupted in 2008, pro­duc­tiv­ity has grown at a snail’s pace. Oddly, the smart­phones’ magic com­put­ing power does not seem to off­set the slow­down in ef­fi­ciency gains in man­u­fac­tur­ing and stan­dard ser­vices. For al­most a decade, an­nual pro­duc­tiv­ity growth in the ad­vanced economies has been close to 1%, ver­sus 2% pre­vi­ously.

This may be a tem­po­rary lull or a sta­tis­ti­cal il­lu­sion. But with no ev­i­dence that it will end, pol­i­cy­mak­ers have down­graded their fore­casts. Since 2010, the US Con­gres­sional Bud­get Of­fice has low­ered its outlook for pro­duc­tiv­ity growth in the decade to 2020 from 25% to 16%; so has the United King­dom’s Of­fice for Bud­get Re­spon­si­bil­ity, re­duc­ing its forecast from 22% to 14% pro­duc­tiv­ity growth. Ev­ery­one is ad­just­ing to leaner times.

The surest way to buck this trend is to in­vest in ed­u­ca­tion, pro­mote in­no­va­tion, and fos­ter ef­fi­ciency. In Europe, es­pe­cially, a broad ar­ray of re­forms could con­trib­ute to bridg­ing a grow­ing ef­fi­ciency gap with the US. The ECB can ex­hort or in­cen­tivise, but it is gov­ern­ments that must act.

Turn now to cur­rent growth. In 2015, eu­ro­zone out­put barely ex­ceeded its 2008 level, a dis­mal per­for­mance for which slug­gish pro­duc­tiv­ity growth can­not be blamed. De­spite con­sid­er­able slack in the econ­omy, growth in 2015 was a dis­ap­point­ing 1.5%, and the ECB ex­pects just 1.4% growth this year. This is far bet­ter than the con­trac­tion that oc­curred from 2011 to 2013, but one would ex­pect a growth surge in an econ­omy ben­e­fit­ing from a favourable ex­change rate, record-low in­ter­est rates and the plunge in oil prices.

Aus­ter­ity is not the cul­prit. Whereas pre­ma­ture con­sol­i­da­tion of pub­lic bud­gets was largely re­spon­si­ble for caus­ing a dou­bledip re­ces­sion five years ago, fis­cal pol­icy has been broadly neu­tral since 2015.

Part of the ex­pla­na­tion is the slow­down of the emerg­ing economies. But such ex­ter­nal fac­tors also ap­ply to the UK and Swe­den, yet their growth rates are 2-3%. The truth is that the eu­ro­zone lacks in­ter­nal mo­men­tum. De­spite in­come growth, house­holds are re­luc­tant to con­sume and build; and, de­spite a surge in prof­its, com­pa­nies are not in­clined to take risks and in­vest.

One rea­son for wari­ness is that the fu­ture looks bleak. This is why re­forms that strengthen the econ­omy in the medium term can help in the short term, too. An­other rea­son is that the past weighs too heav­ily on the present: be­cause in­fla­tion is so low, ac­cu­mu­lated debt does not go away and agents are forced to save to pay it down. Fi­nally, un­em­ploy­ment in parts of the eu­ro­zone re­mains too high for house­holds to re­gain con­fi­dence, while the fis­cal stance is not dis­trib­uted across coun­tries in a way that max­imises growth prospects. This en­dur­ing malaise sus­tains be­low-tar­get in­fla­tion, which in turn keeps real in­ter­est rates too high.

With the econ­omy more

frag­ile than

it should be, the ECB has crossed one Ru­bi­con af­ter an­other in or­der to spark in­fla­tion. De­spite re­newed ef­forts, how­ever, the bat­tle re­mains un­de­cided.

A third ques­tion must there­fore be asked: What could the eu­ro­zone do if con­fronted with a se­vere de­te­ri­o­ra­tion in the global en­vi­ron­ment – for ex­am­ple, a pre­cip­i­tous in­ter­est-rate hike in the United States or an out­right re­ces­sion in China?

In such a case, pri­vate de­mand would con­tract; and, with heav­ily in­debted gov­ern­ments keen to avoid be­ing caught off guard by a surge in risk aver­sion, pub­lic de­mand would not come to the res­cue. The mem­ory of the 2011 sovereign-debt cri­sis re­mains fresh, and many of­fi­cials would re­frain from us­ing fis­cal pol­icy to prop up the econ­omy. At the same time, the ECB would have reached the limit of quan­ti­ta­tive eas­ing.

But to let a new re­ces­sion hap­pen af­ter a short and fee­ble re­cov­ery would be re­garded by cit­i­zens as a ma­jor pol­icy fail­ure, which would fur­ther weaken sup­port for the euro.

Against this back­ground, the ECB is openly pon­der­ing the right re­sponse. In a re­cent in­ter­view, Peter Praet, its chief econ­o­mist, ex­plic­itly noted that “all cen­tral banks” can print money and send checks to each and ev­ery cit­i­zen – a last-re­sort op­tion known as “he­li­copter money.” Be­cause house­holds would spend part of the wind­fall, a he­li­copter drop would boost both do­mes­tic de­mand and the price level.

He­li­copter money raises both le­gal and tech­ni­cal dif­fi­cul­ties. More fun­da­men­tally, ortho­dox econ­o­mists claim that it would be a quasi-fis­cal op­er­a­tion for which the cen­tral bank has no ex­plicit man­date. Its ad­vo­cates re­ply that the ECB does have a man­date to keep in­fla­tion close to 2%, and that it should con­sider all op­tions – even highly un­con­ven­tional ones – to achieve that tar­get.

It is true that a he­li­copter drop would be func­tion­ally equiv­a­lent to a di­rect gov­ern­ment trans­fer to house­holds, fi­nanced by cen­tral banks’ per­ma­nent is­suance of money. So he­li­copter money, while con­sis­tent with the ECB’s price sta­bil­ity man­date, would in­deed blur the distinc­tion be­tween mone­tary and fis­cal poli­cies.

Could an ex­plic­itly fis­cal op­tion be em­braced in­stead? As­sum­ing in­di­vid­ual gov­ern­ments would not want to spend, the eu­ro­zone as an en­tity could bor­row to finance growth-en­hanc­ing poli­cies. A sort of beefed-up Juncker plan (the Euro­pean Com­mis­sion pres­i­dent’s scheme to in­vest EUR 315 bln over three years), based on pre­s­e­lected projects to be ac­ti­vated when the time is right, would pro­vide a sig­nif­i­cant hedge against the risk of re­ces­sion.

Such projects could be in­vest­ments that would help limit global warm­ing, or in­vest­ments to equip the la­bor force for the dig­i­tal econ­omy. Bor­row­ing would be car­ried out jointly and should be backed by a ded­i­cated source, ei­ther a tax or a de­fined GDP-based con­tri­bu­tion that would en­able the eu­ro­zone to pay down its debt.

The po­lit­i­cal dif­fi­cul­ties in­her­ent in such a scheme would no doubt make agree­ment dif­fi­cult. It is not clear whether eu­ro­zonewide bor­row­ing would be eas­ier to con­tem­plate than an ECB-en­gi­neered quasi­fis­cal trans­fer. What is clear is that the eu­ro­zone should eval­u­ate these op­tions, be­cause ei­ther one might well be needed sooner or later.